IARCP Top 10 risk stories

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International Association of Risk and Compliance
Professionals (IARCP)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA
Tel: 202-449-9750 www.risk-compliance-association.com

Top 10 risk and compliance management related news stories
and world events that (for better or for worse) shaped the week's
agenda, and what is next

George Lekatis
President of the IARCP
Dear Member,
We have some very interesting principles for the supervision of
financial conglomerates.
What I really enjoyed:
“Supervisors should require that financial conglomerates not make overly
ambitious diversification assumptions or imprudent correlation claims,
particularly for capital adequacy and solvency purposes”.
Also:
“While it is possible that the spread of activities within a financial
conglomerate may create diversification effects and reduce correlation, it
is also true that membership of a financial conglomerate group may
create “group risks” in the form of financial contagion, reputational
contagion, ratings contagion (where a subsidiary accesses capital
through a parent’s credit rating and then suffers stress following the
utilisation of the capital), double/multiple-gearing (use of same capital
more than once within a group), excessive leveraging (upgrade in the
quality of capital as it moves through a group), and regulatory arbitrage.
Read more at Number 1

Welcome to the Top 10 list.
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International Association of Risk and Compliance Professionals (IARCP)
www.risk-compliance-association.com

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Joint Forum, Principles for the supervision of
financial conglomerates
Corporate Governance
Broadly, corporate governance describes the
processes, policies and laws that govern how a
company or group is directed, administered or
controlled.
It defines the set of relationships between a
company’s management, its board, its
shareholders, and other recognised stakeholders.

Final Basel III Rules in
Australia
Australian Prudential
Regulation Authority (APRA)
To: All locally incorporated authorised deposit-taking institutions
Basel III capital: interim arrangements for Additional Tier 1 and Tier 2
capital instruments

Public Hearings on the draft factual Report of
the EU-US Insurance Regulatory Dialogue
Project

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Five Questions about the Federal Reserve and
Monetary Policy
Chairman Ben S. Bernanke, at the Economic Club of

Adoption of Updated
EDGAR Filer Manual

The Securities and
Exchange Commission (the Commission) is adopting revisions to the
Electronic Data Gathering, Analysis, and Retrieval System (EDGAR)
Filer Manual and related rules to reflect updates to the EDGAR system.

Dealing with financial systemic risk:
the contribution of macroprudential
policies
Panel remarks by Jaime Caruana,
General Manager of the Bank for
International Settlements, Central
Bank of Turkey/G20 Conference on
"Financial systemic risk", Istanbul

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EU to Gabriel Bernardino (EIOPA)

2013 work programme
European Securities and Markets
Authority

ESMA’s key objectives and priorities in 2013

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Solvency II – monitoring the ongoing
appropriateness of internal models

Julian Adams, Director, Insurance

In June 2012 I wrote to all firms in our internal
model approval process to share our thinking on the way we will monitor
the ongoing appropriateness of internal models after approval.

The UK Corporate
Governance Code
Important parts
The first version of the UK Corporate Governance Code (the Code) was
produced in 1992 by the Cadbury Committee.

Its paragraph 2.5 is still the classic definition of the context of the Code:

“Corporate governance is the system by which companies are directed
and controlled. Boards of directors are responsible for the governance of
their companies.

The shareholders’ role in governance is to appoint the directors and the
auditors and to satisfy themselves that an appropriate
governance structure is in place.

The responsibilities of the board include setting the company’s strategic
aims, providing the leadership to put them into effect, supervising the
management of the business and reporting to shareholders on their
stewardship.
The board’s actions are subject to laws, regulations and the shareholders
in general meeting.”
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NUMBER 1

Joint Forum, Principles for the
supervision of financial conglomerates
Corporate Governance
Broadly, corporate governance describes the
processes, policies and laws that govern how a
company or group is directed, administered or
controlled.
It defines the set of relationships between a
company’s management, its board, its
shareholders, and other recognised
stakeholders.
Corporate governance also provides the structure through which the
objectives of the company are set, and the means of attaining those
objectives and monitoring performance are determined.
Good corporate governance should provide proper incentives for the
board and management to pursue objectives that are in the interests of
the company and its shareholders and should facilitate effective
monitoring.
The presence of an effective corporate governance system, within an
individual company or group and across an economy as a whole, helps to
provide a degree of confidence that is necessary for the proper
functioning of a market economy.
Financial conglomerates are often complex groups with multiple
regulated and unregulated financial and other entities.

Given this inherent complexity, corporate governance must carefully
consider and balance the combination of interests of recognised
stakeholders of the ultimate parent, and the regulated financial and other
entities of the group.

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Ensuring that a common strategy supports the desired balance and that
regulated entities are compliant with regulation on an individual and on
an aggregate basis should be a goal of the governance system.

This governance system is the fiduciary responsibility of the board of
directors.

When assessing corporate governance across a financial conglomerate,
supervisors should apply these principles in a manner that is appropriate
to the relevant sectors and the supervisory objectives of those sectors.

This section describes the elements of the governance system most
relevant to financial conglomerates, and how they should be assessed by
supervisors.

Corporate governance in financial conglomerates

10. Supervisors should seek to ensure that the financial conglomerate
establishes a comprehensive and consistent governance framework
across the group that addresses the sound governance of the financial
conglomerate, including unregulated entities, without prejudice to the
governance of individual entities in the group.

Implementation criteria

10(a) Supervisors should require that the corporate governance
framework of the financial conglomerate has minimum requirements for
good governance of the entities of the financial conglomerate which allow
for the prudential and legal obligations of its constituent entities to be
effectively met.

The ultimate responsibility for the sound and prudent management of a
financial conglomerate rests with the board of the head of the financial
conglomerate.

10(b) Supervisors should require that the financial conglomerate
emphasises a high degree of integrity in the conduct of its affairs.
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10(c) Supervisors should seek to ensure that the corporate governance
framework appropriately balances the diverging interests of constituent
entities and the financial conglomerate as a whole.

10(d) Supervisors should require that the governance framework respects
the interests of policy holders and depositors (where relevant), and should
seek to ensure that it respects the interests of other recognised
stakeholders of the financial conglomerate and the financial soundness of
entities in the financial conglomerate.

10(e) Supervisors should require that the governance framework includes
adequate policies and processes that enable potential intra-group
conflicts of interest to be avoided, and actual conflicts of interest to be
identified and managed.

Explanatory comments

10.1 The corporate governance framework should address where
appropriate:

• Alignment to the structure of the financial conglomerate;

• Financial soundness of the significant owners;

• Suitability of board members, senior management and key persons in
control functions including their ability to make reasonable and impartial
business judgments;

• Fiduciary responsibilities of the boards of directors and senior
management of the head company and material subsidiaries;

• Management of conflicts of interest, in particular at the intra-group level
and remuneration policies and practices within the financial
conglomerate; and

• Internal control and risk management systems and internal audit and
compliance functions for the financial conglomerate.
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10.2 The group’s corporate governance framework should notably include
a strong risk management framework (refer to the Risk Management
section), a robust internal control system, effective internal audit and
compliance functions, and ensure that the group conducts its affairs with
appropriate independence and a high degree of integrity.

10.3 Group-wide governance not only involves the governance of the head
of the financial conglomerate, but also applies group-wide to all material
activities and entities of the financial conglomerate.

10.4 In the event the local corporate governance requirements applicable
to any particular material entity in the financial conglomerate are below
the group standards, the more stringent group corporate governance
standards should apply, except where this would lead to a violation of
local law.

10.5 Supervisors should require that the corporate governance framework
of the financial conglomerate includes a code of ethical conduct.

10.6 Supervisors should require that the financial conglomerate have in
place policies focused on identifying and managing potential intra-group
conflicts of interest, including those that may result from intra-group
transactions, charges, up streaming dividends, and risk-shifting.

The policies should be approved by the board of the head of the financial
conglomerate and be effectively implemented throughout the group.

The policies should recognise the long-term interest of the financial
conglomerate as a whole, the long term interest of the significant entities
of the financial conglomerate, the stakeholders within the financial
conglomerate, and all applicable laws and regulations.

Structure of the financial conglomerate

11. Supervisors should seek to ensure that the financial conglomerate has
a transparent organisational and managerial structure, which is
consistent with its overall strategy and risk profile and is well understood
by the board and senior management of the head company.
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11(a) Supervisors should understand the financial conglomerate’s group
structure and the impact of any proposed changes to this structure.

11(b) Supervisors should assess the ownership structure of the financial
conglomerate, including the financial soundness and integrity of its
significant owners.

11(c) Supervisors should seek to ensure that the structure of the financial
conglomerate does not impede effective supervision. Supervisors may
seek restructuring under appropriate circumstances to achieve this, if
necessary.

11(d) Supervisors should seek to ensure that the board and senior
management of the head of the financial conglomerate are capable of
describing and understanding the purpose, structure, strategy, material
operations, and material risks of the financial conglomerate, including
those of unregulated entities that are part of the financial conglomerate
structure.

11(e) Supervisors should assess and monitor the financial conglomerate's
process for approving and controlling structural changes, including the
creation of new legal entities.

11(f) Where the financial conglomerate is part of a wider group,
supervisors should require that the board and senior management of the
head of the financial conglomerate have governance arrangements that
enable material risks stemming from the wider group structure to be
identified and appropriately assessed by relevant supervisory authorities.

11(g) Supervisors should seek to ensure that there is a framework
governing information flows within the financial conglomerate and
between the financial conglomerate and entities of the wider group (eg
reporting procedures).

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11.1 A financial conglomerate may freely set its functional, hierarchical,
business and/or regional organisation, provided all entities within the
financial conglomerate comply with their relevant sectoral and legal
frameworks.

11.2 Elements to be considered for assessing the significant ownership
structure of the financial conglomerate may include the identification of
significant owners, including the ultimate beneficial owners, the
transparency of their ownership structure, their financial information, and
the sources of their initial capital and all other requirements of national
authorities.

At a minimum, the necessary qualities of significant owners relate to the
integrity demonstrated in personal behaviour and business conduct, as
well as to the ability to provide additional support when needed.

11.3 Supervisors should seek to ensure that a financial conglomerate has
an organisational and managerial structure that promotes and enables
prudent management, and if necessary, orderly resolution aligned with
corresponding sectoral requirements.

Reporting lines within the financial conglomerate should be clear and
should facilitate information flows within the financial conglomerate,
both bottom-up and top-down.

11.4 Supervisors should be satisfied that the board and senior
management of the head of the financial conglomerate understand and
influence the evolution of an appropriate group legal structure in
alignment with the approved business strategy and risk profile of the
financial conglomerate, and understand how the various elements of the
structure relate to one another.

Where a financial conglomerate creates many legal entities, their number
and, particularly, the interconnections and transactions between them,
may pose challenges for the design of effective corporate governance
arrangements.
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This risk should be recognised and managed.

This is particularly the case where the organisational and managerial
structure of the financial conglomerate deviates from the legal entity
structure of the financial conglomerate.

11.5 Supervisors should assess changes to the group structure and how
these changes impact its soundness, especially where such changes cause
the financial conglomerate to engage in activities and/or operate in
jurisdictions that impede transparency or do not meet international
standards stemming from sectoral regulation.

Suitability of board members, senior managers and key persons
in control functions

12. Supervisors should seek to ensure that the board members, senior
managers and key persons in control functions in the various entities in a
financial conglomerate possess integrity, competence, experience and
qualifications to fulfil their role and exercise sound objective judgment.


12(a) Supervisors should be satisfied of the suitability of board members,
senior managers and key persons in control functions.

12(b) Supervisors should require financial conglomerates to have
satisfactory processes for periodically assessing suitability.

12(c) Supervisors should require that the members of the boards of the
head of the financial conglomerate and of its significant subsidiaries act
independently of parties and interests external to the wider group; and
that the board of the head of the financial conglomerate include a number
of members acting independently of the wider group (including owners,
board members, executives, and staff of the wider group).

12(d) Supervisors should communicate with the supervisors of other
regulated entities within the conglomerate when board members, senior
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management and key persons in control functions are deemed not to
meet their suitability tests.


12.1 Board members, senior managers and key persons in control
functions need to have appropriate skills, experience and knowledge, and
act with care, honesty and integrity, in order to to make reasonable and
impartial business judgments and strengthen the protection afforded to
recognised stakeholders.

To this end, institutions need to prudently manage the risk that persons
in positions of responsibility may not be suitable.

Suitability criteria may vary depending on the degree of influence on or
the responsibilities for the financial conglomerate.

12.2 Supervisors of regulated entities of the financial conglomerate are
subject to statutory and other requirements in applying suitability tests to
these entities in their jurisdiction.

The organisational and managerial structure of financial conglomerates
adds elements of complexity for supervisors seeking to ensure the
suitability of persons.

For instance, the management of regulated entities within the financial
conglomerate can be extensively influenced by persons who are not
directly responsible for such functions.

A group-wide perspective regarding suitability of persons is intended to
close any loopholes in this respect.

Supervisors may rely on assessments made by other relevant supervisors
in this area regarding suitability.

Alternatively they may decide on concerted supervisory actions regarding
suitability if required.

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12.3 In order to meet suitability requirements, board members, senior
managers and key persons in control functions, both individually and
collectively, should have and demonstrate the ability to perform the duties
or to carry out the responsibilities required in their position.

Competence can generally be judged from the level of professionalism (eg
pertinent experience within financial industries or other businesses)
and/or formal qualifications.

12.4 Serving as a board member or senior manager of a company (from
the wider group) that competes or does business with the regulated
entities in the financial conglomerate can compromise independent
judgment and create conflicts of interest, as can cross-membership on
boards.

A board’s ability to exercise objective judgment independent of the views
of executives and of inappropriate political or personal interests can be
enhanced by recruiting members from a sufficiently broad population of
candidates.

The key characteristic of independence is the ability to exercise objective,
independent judgment after fair consideration of all relevant information
and views without undue influence from executives or from inappropriate
external parties and interests and while taking into account the
requirements of applicable law.

Responsibility of the board of the head of the financial
conglomerate

13. Supervisors should require that the board of the head of the financial
conglomerate appropriately defines the strategy and risk appetite of the
financial conglomerate, and ensures this strategy is implemented and
executed in the various entities, both regulated and unregulated.

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13(a) Supervisors should require that the board of the head of the financial
conglomerate has in place a framework for monitoring compliance with
the strategy and risk appetite across the financial conglomerate.

13(b) Supervisors should require that the board of the head of the financial
conglomerate regularly assesses the strategy and risk appetite of the
financial conglomerate to ensure it remains appropriate as the
conglomerate evolved.

13(c) Where the financial conglomerate is part of a wider group,
supervisors should assess whether the head is managing its relationship
with the wider group and ultimate parent in a manner that is consistent
with the governance framework of the financial conglomerate.

13(d) Supervisors should require that a framework is in place which seeks
to ensure resources are available across the financial conglomerate for
constituent entities to meet both the group and their own entity’s
governance standards.


13.1 Supervisors should assess if the board of directors exercises adequate
oversight over the management of the head of the financial conglomerate.

This includes assessing the actions taken by the board of the head to
define the strategy for the financial conglomerate and ensure the
consistency of the operations of the various entities in the financial
conglomerate with such strategy.

To this end, the head company should set up an adequate corporate
governance framework in line with the structure, business and risks of the
financial conglomerate and its entities and applicable laws.

This framework should ensure that the strategy is implemented and
monitored throughout the financial conglomerate and reviewed on a

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regular basis and following material change including due to growth,
increased complexity, geographic expansion, etc.

13.2 The head company should exercise adequate oversight of
subsidiaries, both regulated and unregulated, while respecting
independent legal and governance responsibilities.

Supervisors should satisfy themselves that entities within a financial
conglomerate adhere to the same group-wide corporate governance
principles or at least apply policies that remain consistent with these
principles.

The board of a regulated subsidiary of a financial conglomerate will retain
and set its own corporate governance responsibilities and practices in line
with its own legal requirements or in proportion to its size or business.

These should not, however, conflict with the broader financial
conglomerate corporate governance framework.

Appropriate governance arrangements will address arrangements such
that legal or regulatory provisions or prudential rules of regulated
subsidiaries will be known and taken into account by the head company.

13.3 Where the financial conglomerate is part of a wider group structure,
the head of the financial conglomerate is responsible for managing the
relationship with its wider group.

This includes ensuring there are appropriate arrangements for capital and
liquidity management, assessing any material risk impact that may come
from decisions made at its ownership level, service level agreements,
reporting lines and regular top-level consultations with related companies
in the wider group and the ultimate parent.

13.4 For smaller institutions within a larger conglomerate, it may be
unnecessary to duplicate systems and controls.

Such smaller institutions can rely on the systems and controls of the head
if they have assessed that this is suitable to address group risks.
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13.5 Supervisors should be satisfied with the amount and quality of
information they receive from the head company of the financial
conglomerate on its strategy, risk appetite and corporate governance
framework.

Remuneration in a financial conglomerate

14. Supervisors should require that the financial conglomerate has and
implements an appropriate remuneration policy that is consistent with its
risk profile. The policy should take into account the material risks that
organisation is exposed to, including those from its employees’ activities.


14(a) Supervisors should require that an appropriate remuneration policy
consistent with established international standards is in place and
observed at all levels and across jurisdictions in the financial
conglomerate.

An appropriate policy aligns risk-takers’ variable remuneration with
prudent risk taking, promotes sound and effective risk management, and
takes into account any other appropriate factors.

The overarching objective of the policy should be consistent across the
group but can allow for reasonable differences based on the nature of the
constituent entities/units and local legal requirements.

14 (b) Supervisors should require that ultimate oversight of the
remuneration policy rest with the financial conglomerate’s head
company.

14(c) Supervisors should require that the remuneration of board members,
senior managers and key persons in control functions be determined in a
manner that does not incentivise them to disregard the obligations they
owe to the financial conglomerate or any of its entities, nor to otherwise
act in a manner contrary to any legal or regulatory obligations.

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14(d) Supervisors should require that the risks associated with
remuneration are reflected in the financial conglomerate’s broader risk
management framework.

For example, staff engaged in financial and risk control at the group-wide
level should be compensated in a manner that is consistent with their
control role and should be involved in designing incentive arrangements,
and assessing whether such arrangements encourage imprudent
risk-taking.

14(e) Supervisors should require that the variable remuneration received
by risk management and control personnel is not based substantially on
the financial performance of the business units that they review but rather
on the achievement of the objectives of their functions (eg adherence to
internal controls).


14.1 Remuneration is a key aspect of any governance framework and
needs to be properly considered in order to mitigate the risks that may
arise from poorly designed remuneration arrangements.

The risks associated with remuneration should be reflected in the
financial conglomerate’s broader risk management framework.

14.2 Remuneration may serve important objectives, including attracting
skilled staff, promoting better organisation-wide and employee
performance, promoting retention, providing retirement security and
allowing personnel costs to vary with revenues.

It is also clear, however, that ill-designed compensation arrangements
can provide incentives to take risks that are not consistent with the long
term health of the organisation. Such risks and misaligned incentives are
of particular supervisory interest.

14.3 Ultimately a financial conglomerate’s remuneration policy should
aim to ensure effective governance of remuneration, alignment of

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remuneration with prudent risk-taking, and engagement of recognised
stakeholders.

14.4 Supervisors should ensure that the governance system identifies and
closes loopholes that allow the circumvention of conglomerate, sectoral or
entity-level remuneration requirements.

14.5 Board members, senior managers and key persons in control
functions should be measured against performance criteria tied not only
to the short-term, but also to the long-term interest of the financial
conglomerate as a whole.

V. Risk Management

Since financial conglomerates are in the business of risk-taking, good risk
management is a crucial focus of supervision.

This section provides principles for the sound and comprehensive
supervision of risk management frameworks in financial conglomerates.
It covers factors ranging from risk culture and tolerance, to the use of
stress and scenario testing and the monitoring of risk concentrations.

Risk management framework

21. Supervisors should require that an independent, comprehensive and
effective risk management framework, accompanied by a robust system
of internal controls, effective internal audit and compliance functions, is
in place for the financial conglomerate.


21(a) Supervisors should ensure that the risk management framework is
comprehensive, consistent across entities supervised in all sectors and
covers the risk management function, risk management processes and
governance, and systems and controls.

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Risk management function

21(b) Supervisors should require that the risk management function is
independent from the business units and has a sufficient level of authority
and adequately skilled resources to carry out its functions.

21(c) Supervisors should require that the risk management function
generally has a direct reporting line to the board and senior management
of the financial conglomerate.

21(d) Supervisors should, where they consider it appropriate, require that
a separate risk management committee at the board of directors level is
established by the financial conglomerate.

Risk management governance
21(e) Supervisors should require that the board of the head of the financial
conglomerate has overall responsibility for the financial conglomerate’s
group-wide risk management, internal control mechanism, internal audit
and compliance functions to ensure that the group conducts its affairs
with a high degree of integrity.

21(f) Supervisors should require that the financial conglomerate has an
established enterprise-wide risk management process for, among others,
periodically reviewing the effectiveness of the group-wide risk
management framework and for ensuring appropriate aggregation of
risks.

21(g) Supervisors should require that the risk management process cover
identification, measurement, monitoring and controlling of risk types (eg
credit risk, operational risk, strategic risk, liquidity risk) and these be
linked where appropriate to specific capital requirements.

Systems and controls

21(h) Supervisors should require that financial conglomerates have in
place adequate, sound and effective risk management processes and
internal control mechanisms at the level of the financial conglomerate,
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including sound administrative and accounting procedures.

21(i) Supervisors should require that risk management processes and
internal control mechanisms of a financial conglomerate are
appropriately documented and, at a minimum, take into account the:

• nature, scale and complexity of its business;

• diversity of its operations, including geographical reach ;

• volume, frequency and size of its transactions;

• degree of risk associated with each area of its operation;

• interconnectedness of the entities within the financial conglomerate
(using intra-group transactions and exposures reporting as one measure);
and

• sophistication and functionality of information and reporting systems.


21.1 Financial conglomerates, irrespective of their particular mix of
business lines or financial sectors, are in the business of risk taking.
Therefore, strong risk management is of paramount importance.

21.2 The comprehensive risk management framework and process should
include board and senior management oversight.

21.3 In identifying, evaluating, monitoring, controlling and mitigating
material risks (from regulated and unregulated activities), financial
conglomerates should consider the prospect for these to change over time
and prepare themselves accordingly.

21.4 The risk management processes and internal control mechanisms of
a financial conglomerate should include clear arrangements for
delegating authority and responsibility; segregation of the functions that
involve committing the financial conglomerate’s funds and accounting
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for assets and liabilities; reconciliation of these processes; safeguarding of
the financial conglomerate’s assets; and appropriate independent internal
audit and compliance functions to test adherence to these controls as well
as applicable laws and regulations.

Risk tolerance levels and risk appetite policy

23. Supervisors should require that the financial conglomerate establishes
appropriate board approved, group-wide risk tolerance levels and a risk
appetite policy.


23(a) Supervisors should require that key staff, senior management and
the board of the head of the financial conglomerate be aware of and
understand the financial conglomerate’s risk tolerance levels and risk
appetite policy.

23(b) Supervisors should require that the financial conglomerate identify
and measure against risk tolerance limits (and in line with its risk appetite
policy) the risk exposure of the financial conglomerate on an on-going
basis in order to identify potential risks as early as possible.

This may include looking at risks by territory, by line of business, or by
financial sector.

23.1 Financial conglomerates should establish risk tolerance levels and a
risk appetite policy which set the tone for acceptable and unacceptable
risk taking.

This should be aligned with the financial conglomerate’s business
strategy, risk profile and capital plan.

23.2 A financial conglomerate’s risk tolerance should be kept under
periodic review so as to ensure that it remains relevant and takes account
of the changing dynamics of the financial conglomerate.
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The financial conglomerate’s risk appetite policy is re-assessed regularly
with respect to new business opportunities, changes in risk capacity and
tolerance, and operating environment.

New business

24. Supervisors should require that the financial conglomerate carries out
a robust risk assessment when entering into new business areas.


24(a) Supervisors should, where they consider it appropriate, review the
risk assessment carried out by a financial conglomerate in the context of
entering into new business.

24(b) Supervisors should require that financial conglomerates not expand
into new products unless they have put in place adequate processes,
controls and systems (such as IT) to manage them.

24(c) Supervisors should make sure that a financial conglomerate carries
out the ongoing risk assessment after entering into new business areas.


24.1 At the time of assessing whether or not to enter into a new business
area or product line, it is imperative that financial conglomerates
undertake risk assessments and analyses to identify potential risks
inherent in the new activity.

24.2 They should seek to understand the potential interaction between the
risks of the new activity and the existing risk profile of the financial
conglomerate.

This should include a consideration of whether the new activity could
adversely affect the risk appetite or risk tolerance of the financial
conglomerate.

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Outsourcing

25. Supervisors should require that, when considering whether to
outsource a particular function, the financial conglomerate carries out an
assessment of the risks of outsourcing, including the appropriateness of
outsourcing a particular function.


25(a) Supervisors should require that financial conglomerates have
processes and criteria in place to review decisions to outsource a function
in order to ensure that such outsourcing does not imply delegation of
responsibility for that function.

25(b) Supervisors should be satisfied that the decision to outsource a
function does not impede effective group-wide supervision of the
financial conglomerate.


25.1 It is important that supervisors be satisfied that, when considering
whether to outsource a particular function, financial conglomerates have
considered the risks involved and the appropriateness of outsourcing a
particular function.

This includes considering the appropriateness of outsourcing to a
particular provider and the cumulative risks of all outsourced functions.

The supervisor should require the financial conglomerate to review the
provider in advance to ensure it is in a position to provide the services,
comply with the contractual terms, and observe all applicable laws and
regulations.

25.2 Supervisors should periodically assess the outsourced function with
regard to policy compliance, risk management measures and control
procedures.

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25.3 Outsourcing should never result in a delegation of responsibility for a
given function.

There may be certain functions within financial conglomerates which
should not be outsourced under any circumstances, while there may be
some that may only be outsourced if certain safeguards are put in place.

Stress and scenario testing

26. Supervisors should require, where appropriate, that the financial
conglomerate periodically carries out group-wide stress tests and
scenario analyses for its major sources of risk.


26(a) Supervisors should require that stress tests are sufficiently severe,
forward looking and flexible.

They should cover an appropriate set of business activities and include a
variety of different types of tests such as sensitivity analyses, scenario
analyses and reverse stress testing.

26(b) Supervisors should require the financial conglomerate to document
its stress and scenario tests, including reverse stress tests.

Stress tests should be conducted under a robust governance framework
that encompasses policies, procedures, and adequate documentation of
procedures as well as validation of results.

26(c) Supervisors should require that the group-wide stress tests and
scenario analyses conducted by the financial conglomerate are
appropriate to the nature, scale and complexity of those major sources of
risk and to the nature, scale and complexity of the financial
conglomerate’s business.

26(d) Supervisors should require that group-wide stress tests and scenario
analyses include a group-wide approach (which takes account of the

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interaction between different parts of the group and different risk types)
and consider the results of sectoral stress tests.

26(e) Supervisors should require that, when carrying out reverse stress
tests, a financial conglomerate identifies a range of adverse
circumstances which would cause its business to fail and assess the
likelihood of such events crystallising.


26.1 A financial conglomerate should have a good understanding of
correlation between its respective sectors and the heterogeneity of such
risks when conducting its stress tests.

Stress tests should be robust and should consider sufficiently adverse
circumstances.

The group-wide stress test analysis should measure and evaluate the
potential impact on individual entities.

26.2 Attention should be paid to covering all risks, including off-balance
sheet items.

For example, a financial conglomerate’s stress tests and scenario analyses
should take into account the risk that the financial conglomerate may
have to bring back on to its consolidated balance sheet the assets and
liabilities of off-balance sheet entities as a result of reputational
contagion, notwithstanding the appearance of legal risk transfer.

26.3 Where reverse stress tests reveal a risk of business failure that is
unacceptably high relative to the financial conglomerate’s risk appetite or
risk tolerance, the financial conglomerate should evaluate and adopt,
where appropriate, effective arrangements, processes, systems or other
measures to prevent or mitigate that risk.

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Risk aggregation

27. Supervisors should require that the financial conglomerate aggregate
the risks to which it is exposed in a prudent manner.


27(a) Supervisors should require that financial conglomerates ***not
make overly ambitious diversification assumptions*** or imprudent
correlation claims, particularly for capital adequacy and solvency
purposes.

27(b) Supervisors should require financial conglomerates to have
adequate resources and systems (including IT) for the purpose of
aggregating risks.


27.1 Risk aggregation should include a clear understanding of
assumptions and be robust enough to support a comprehensive
assessment of risk.

27.2 While it is possible that the spread of activities within a financial
conglomerate may create diversification effects and reduce correlation, it
is also true that membership of a financial conglomerate group may
create “group risks” in the form of financial contagion, reputational
contagion, ratings contagion (where a subsidiary accesses capital
through a parent’s credit rating and then suffers stress following the
utilisation of the capital), double/multiple-gearing (use of same capital
more than once within a group), excessive leveraging (upgrade in the
quality of capital as it moves through a group), and regulatory arbitrage
(it is important that risks are assessed at the financial conglomerate level
as well as at the level of its constituent parts).

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Risk concentrations and intra-group transactions and exposures

28. Supervisors should require that the financial conglomerate has in
place effective systems and processes to manage and report group-wide
risk concentrations and intra-group transactions and exposures.


28(a) Supervisors should require that the financial conglomerate has in
place effective systems and processes to identify, assess and report
group-wide risk concentrations (including for the purposes of monitoring
and controlling those concentrations).

28(b) Supervisors should require that the financial conglomerate has in
place effective systems and processes to identify, assess and report
significant intra-group transactions and exposures.

28(c) Supervisors should require the financial conglomerate to report
significant risk concentrations and intra-group transactions and
exposures at the level of the financial conglomerate on a regular basis.

28(d) Supervisors should consider setting quantitative limits and
adequate reporting requirements.


28.1 Supervisors should ensure that financial conglomerates are
managing their risk concentrations and intra-group transactions and
exposures satisfactorily.

28.2 Supervisors should encourage adequate public disclosure of risk
concentrations and intra-group transactions and exposures.

28.3 Supervisors should liaise closely with one another to ascertain each
other’s concerns and coordinate as deemed appropriate any supervisory
action relative to risk concentrations and intra-group transactions and
exposures within the financial conglomerate.
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28.4 Supervisors should deal effectively with material risk concentrations
and intra-group transactions and exposures that are considered to have a
detrimental effect on the regulated entities or the financial conglomerate
as a whole.

Off-balance sheet activities
29. Supervisors should require that off-balance sheet activities, including
special purpose entities, are brought within the scope of group-wide
supervision of the financial conglomerate, where appropriate.
29(a) Supervisors should require that there is a process for determining
whether the nature of the relationship between the financial conglomerate
and a special purpose entity (SPE) requires the SPE to be fully or
proportionally consolidated into the financial conglomerate for regulatory
purposes.
29(b) Supervisors should require that the financial conglomerate’s stress
tests and scenario analyses take into account the risk associated with off
balance sheet activities.
29(c) Supervisors should require that the overall nature of the relationship
between the financial conglomerate and the SPE is considered including
the risk of contagion from the SPE. This assessment should go beyond
traditional control and influence relationships.
29.1 A financial conglomerate’s risk management framework and
processes should cover the full spectrum of risks to the financial
conglomerate. This includes risks from regulated and unregulated
entities, including SPEs and off-balance sheet activities.
29.2 The fact that a financial conglomerate does not own or control the
SPE in the traditional sense should not mean that it should not be
consolidated.
Other channels of contagion should be considered, such as the provision
of (actual or contingent) liquidity support, reputational risk, and whether

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the assets of the SPE previously belonged to the financial conglomerate
or were third-party assets.
29.3 It is important that financial conglomerates assess all economic risks
and business purposes of an SPE throughout the life of a transaction,
distinguishing between risk transfer and risk transformation.
Financial conglomerates should be particularly aware that, over time, the
nature of these risks can change.
Supervisors should require such assessment to be ongoing and that
management has sufficient understanding of the risks.
29.4 Financial conglomerates should have the capability to aggregate,
assess and report all their SPE exposure risks in conjunction with all other
firm-wide risks.
29.5 Supervisors should regularly oversee and monitor the use of all SPE
activity and assess the implications for the financial conglomerate of the
activities of SPEs, in order to identify developments that can lead to
systemic weakness and contagion or that can exacerbate pro-cyclicality.

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NUMBER 2
Final Basel III Rules in
Australia
Australian Prudential
Regulation Authority
(APRA)
To: All locally incorporated authorised deposit-taking institutions
Basel III capital: interim arrangements for Additional Tier 1 and Tier 2
capital instruments

APRA has released final prudential standards implementing the Basel III
measures to raise the quality, consistency and transparency of the capital
base, including Prudential Standard APS 111 Capital Adequacy:
Measurement of Capital (APS 111).

This letter sets out APRA’s treatment of new Additional Tier 1 and Tier 2
capital instruments issued before the new standard comes into effect on +

To be eligible for inclusion in regulatory capital, all capital instruments
that have not been submitted to APRA for review before close of business
today must comply with the final version of APS 111 issued today.

Instruments that have been submitted to APRA up to and including
today’s date and that were intended to be issued under the current
transitional arrangements (including APRA’s letters to industry dated 27
May 2011 and 30 March 2012), will be assessed against these criteria.

To be counted as eligible regulatory capital, instruments approved by
APRA under these criteria must be issued before close of business on 31
December 2012.

Any questions in relation to this letter should in the first instance be
directed to your Responsible Supervisor.

Yours sincerely
Charles Littrell
Executive General Manager
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Notes

In December 2010, the Basel Committee on Banking Supervision (Basel
Committee) released a package of reforms to raise the level and quality of
regulatory capital in the global banking system (Basel III).

APRA is a member of the Basel Committee and fully supports the
implementation of these reforms.

In September 2011, APRA released a discussion paper outlining its
proposals to implement these Basel III capital reforms in Australia.

APRA subsequently released, in March and June 2012, draft prudential
and reporting standards on which submissions were invited.

In June 2012, APRA also invited submissions on its proposal that certain
capital instruments be subject to Australian law and on its proposed
regulatory capital treatment of joint arrangements.

Fifteen submissions were received on the March and June 2012
consultation packages.

APRA’s capital adequacy prudential and reporting standards

Submissions were broadly supportive of the content of the draft
prudential and reporting standards and mostly sought clarification of
particular provisions.

In response, APRA has:

• clarified its expectations for an ADI’s Internal Capital Adequacy
Assessment Process (ICAAP), which are included in the draft Prudential
Practice Guide CPG 110 Internal Capital Adequacy Assessment
Process and supervisory review (CPG 110) recently released for public
consultation;

• revised its proposed treatment of an ADI’s funding of purchases of its
own capital instruments, including margin loans;
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• removed the ‘profits test’ from Additional Tier 1 and Tier 2 Capital
instruments;

• clarified the operation of the countercyclical capital buffer;

• simplified transitional arrangements for capital issued by consolidated
subsidiaries and held by third parties; and

• made minor changes to the prudential and reporting standards to
improve ease of use.

Submissions raised concerns about APRA’s proposal that certain capital
instruments should be subject to Australian law.

APRA acknowledges these concerns.

In response, it has clarified areas of uncertainty about the loss absorption
and non-viability requirements and has refined its approach to the
question of governing law for capital instruments, such that only those
provisions of capital instrument documentation dealing with loss
absorption and non-viability must be governed by Australian law.

In June 2012, the Basel Committee finalised its proposals to improve
consistency and ease of use of disclosures on capital positions and capital
composition.

These measures, which are to come into effect for reporting periods
ending on or after 30 June 2013, include a common template and
disclosure provisions that, if implemented, would facilitate comparison
between the capital position of banking institutions across jurisdictions.

APRA will consult in early 2013 on these requirements.

Consultation with industry and other interested stakeholders

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P a g e | 34

The Basel III reforms also implement measures relating to external credit
assessment institutions (ECAIs) and to minimise cliff effects arising from
guarantees and derivatives.

Objectives and key requirements of this Prudential Standard
This Prudential Standard requires an authorised deposit-taking
institution (ADI) to maintain adequate capital, on both a Level 1 and
Level 2 basis, to act as a buffer against the risk associated with its
activities.

The ultimate responsibility for the prudent management of capital of
an ADI rests with its Board of directors.

The Board must ensure the ADI maintains an appropriate level and
quality of capital commensurate with the type, amount and
concentration of risks to which the ADI is exposed.

The key requirements of this Prudential Standard are that an ADI
and any Level 2 group must:

- have an Internal Capital Adequacy Assessment Process;

- maintain required levels of regulatory capital;

- operate a capital conservation buffer and, if required, a
countercyclical capital buffer;

- inform APRA of any adverse change in actual or anticipated
capital adequacy; and

- seek APRA’s approval for any planned capital reductions.

Interesting:

An ADI that is part of a group may rely on the ICAAP of the group
provided that the Board of the ADI is satisfied that the group ICAAP
meets the criteria in respect of the ADI.
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Group risk management

8. Paragraphs 9 to 13 of this Prudential Standard apply to an ADI that
heads a conglomerate group.

Where an ADI is part of a conglomerate group headed by an authorised
non-operating holding company (authorised NOHC), the requirements
set out in paragraphs 9 to 13 of this Prudential Standard apply to the ADI
and its subsidiaries.

9. For conglomerate groups headed by an ADI, the Board of the ADI is
responsible for ensuring that comprehensive policies and procedures are
in place to measure, manage, monitor and report overall risk at a group
level.

To ensure that existing Board-approved policies and the relevant controls
remain adequate and appropriate for managing and monitoring overall
group risk, the Board or a board committee must review them regularly
(at least annually) to take account of changing risk profiles of group
entities.

Any material changes to group risk management policies must be
approved by the Board.

10. The Board of an ADI must ensure that the ADI establishes
appropriate policies, systems and procedures to monitor compliance with
APRA’s prudential requirements on a group basis.

To facilitate conglomerate group supervision by APRA, an ADI must:

(a) provide APRA with the following group information:

(i) details of group members (e.g. name, place of incorporation, board
composition, nature of business and any other additional information
required by APRA for a better understanding of the risk profiles of
individual group members);

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P a g e | 36

(ii) management structure of the group (including key risk management
reporting lines);

(iii) intra-group support arrangements (e.g. a specific guarantee of the
obligations of an entity in the group);

(iv) intra-group exposures; and

(v) other information as required by APRA from time to time for the
effective supervision of the group;

(b) notify APRA in accordance with section 62A of the Banking Act of any
breach of a requirement in a prudential standard or a condition of a
banking authority (whether by an ADI in the group or by the group) and
of any circumstances that might reasonably be seen as having a material
impact and potentially adverse consequences for an ADI in the group or
for the overall group;

(c) advise APRA in advance of any proposed changes to the composition
or operations of the group with the potential to materially alter the group’s
overall risk profile (this must include any proposed changes to the ADI’s
stand-alone operations); and

(d) obtain APRA’s prior written approval for the establishment or
acquisition of a regulated presence domestically or overseas.

11. An ADI must provide APRA with descriptions of its group risk
management policies and the procedures used to measure and control
overall group risk (including any material changes thereto).

The ADI should, as best practice, disclose in the group’s full published
annual report each year an outline of its group risk management policies,
including the policies governing dealings between the ADI and other
group members.

12. An ADI must submit a declaration signed by its chief executive officer,
approved by the Board, covering the Level 2 group's risk management
systems within three months of the ADI's annual balance date in
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P a g e | 37

accordance with the declaration requirements in Prudential Standard APS
310 Audit and Related Matters (APS 310).

13. If an ADI qualifies the declaration in paragraph 12, the ADI must
explain the reasons for the qualifications in accordance with the
requirements in APS 310 and provide plans for corrective action.

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NUMBER 3

16 October 2012 - Public Hearings
on the draft factual Report of the
EU-US Insurance Regulatory
Dialogue Project
The EU-US Insurance Regulatory
Dialogue Project organises two public
hearings on the draft factual Report
based on the results of the Project’s seven
technical committees (TC).

The public hearings will take place:

In the USA: on 12 October 2012 at 14.00 – 17.00 hrs EDT in the Grand
Hyatt, Washington DC;

In Belgium: on 16 October 2012 at 10.00 – 13.00 hrs CET in the Centre de
Conférences Albert Borschette, Brussels.

Requests to provide oral statements during the public hearings should be
sent by 10 October 2012 to the following email addresses:
tom.finnell{at}treasury.gov (Washington Hearing) and
Manuela.Zweimueller{at}eiopa.europa.eu (Brussels Hearing).

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The EU-US Dialogue Project
The EU-US Dialogue Project started in early 2012, when the European
Commission (EC), EIOPA, the US National Association of Insurance
Commissioners (NAIC) and the Federal Insurance Office of the US
Department of the Treasury (FIO) agreed to participate in dialogue and a
related project (Project) to contribute to an increased mutual
understanding and enhanced cooperation between the European Union
and the United States to promote business opportunity, consumer
protection and effective supervision.

The objective of the Project, which builds on more than a decade of
EU-US regulatory dialogue, is to deepen insight into the overall design,
function and objectives of the key aspects of the insurance supervisory
regimes in the EU and the U.S, and to identify important characteristics
of both regimes.

Request for the EU-U.S. Dialogue Project for Public Comment
on the Technical Committee Reports

Comparing Certain Aspects of the Insurance Supervisory and
Regulatory Regimes in the European Union and the United
States

To Interested Parties:

The Steering Committee of the EU-U.S. Dialogue Project invites public
comment on the reports of seven technical committees comparing certain
aspects of the insurance supervisory regimes in the European Union and
the United States.

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Introduction to the EU-U.S. Dialogue Project

In the EU, the European Parliament, the Council of the European Union
and the European Commission (EC), technically supported by the
European Insurance and Occupational Pensions Authority (EIOPA), are
modernizing the EU’s insurance regulatory and supervisory regime
through the Solvency II Directive (Directive 2009/138/EC), in place since
2009.

This so-called Framework Directive was the culmination of work begun
in the 1990s to update existing solvency standards in the EU.

Current work aims to further specify the Framework Directive with
technical rules and guidelines, which are necessary for a consistent
application by insurers and supervisors of the framework.

In the United States, the states are the primary regulators of the insurance
industry.

State insurance regulators are members of the National Association of
Insurance Commissioners (NAIC), a standard-setting and regulatory
support organization created and governed by the chief insurance
regulators from the 50 states, the District of Columbia and five U.S.
territories.

As part of an evolutionary process, through the NAIC, state insurance
regulators in the U.S. are currently in the process of enhancing their
solvency framework through the Solvency Modernization Initiative
(SMI).

SMI is an assessment of the U.S. insurance solvency regulation
framework and includes a review of international developments regarding
insurance supervision, banking supervision, and international accounting
standards and their potential use in U.S. insurance regulation.

In early 2012, the EC, EIOPA, the NAIC and the Federal Insurance Office
of the U.S. Department of the Treasury (FIO) agreed to participate in
dialogue and a related project (Project) to contribute to an increased
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P a g e | 41

mutual understanding and enhanced cooperation between the EU and
the U.S. to promote business opportunity, consumer protection and
effective supervision.

The project is considered to be part of and builds on the on-going EU-US
Dialogue which has been in place for over 10 years.

The work is carried out in collaboration with EIOPA and competent
authorities in the EU Member States, and with state insurance regulators
and the NAIC in the United States.

The objective of the Project is to deepen insight into the overall design,
function and objectives of the key aspects the two regimes, and to identify
important characteristics of both regimes.

Project Governance and Process: The Project is led by a six-member
Steering Committee comprised of three EU and three U.S. officials, as
follows:

• Gabriel Bernardino – Chairman of EIOPA

• Edward Forshaw – Manager in the Prudential Policy division, UK
Financial Services Authority, and EIOPA Equivalence Committee Chair

• Karel Van Hulle – Head of Unit for Insurance and Pensions,
Directorate-General Internal Market and Services, EC

• Kevin M. McCarty– Commissioner, Office of Insurance Regulation,
State of Florida, and current President of the NAIC

• Michael McRaith – Director, FIO, United States Department of the
Treasury

• Therese M. (Terri) Vaughan – Chief Executive Officer, NAIC

Since the Project began, the Steering Committee has held several
face-to-face meetings in Basel, Washington DC and Frankfurt, as well as
numerous conference calls.
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In a first step, the topics to be discussed were agreed upon and a process
for information exchange under confidentiality obligations was
established.

The Steering Committee agreed upon seven topics fundamentally
important to a sound regulatory regime and to the protection of
policyholders and financial stability.

The seven topics are:

• Professional secrecy/confidentiality;
• Group supervision;
• Solvency and capital requirements;
• Reinsurance and collateral requirements;
• Supervisory reporting, data collection and analysis;
• Supervisory peer reviews; and
• Independent third party review and supervisory on-site inspections.

A separate Technical Committee (TC) was assembled to address each
topic.

Each TC was comprised of experienced professionals from both the
European Union as well as the United States, specifically, from FIO, the
EC, the NAIC and EIOPA, as well as representatives from state insurance
regulatory agencies in the United States and competent authorities of EU
Member States.

The various professionals who comprised the technical committees were
selected because of their qualifications and experience with respect to the
subject matter of each topic, including insurance regulators and
supervisors, attorneys, accountants, examiners, and other specialists.

The teams worked jointly to develop objective, fact-based reports
intended to summarize the key commonalities and differences between
the Solvency II regime in the EU, and the state-based insurance
regulatory regime in the United States.

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P a g e | 43

Supporting documentation, e.g., regulations, directives, and supervisory
guidance, was exchanged as requested by either side.

The accompanying seven technical committee reports have been jointly
drafted and reflect the consensus views of each respective technical
committee’s members.

No action has been taken by the governing bodies of the organizations
represented on the Steering Committee to formally adopt the draft factual
reports and thus this document should not be considered to express
official views or positions of any organization.

The reports represent the culmination of the initial work from the first
phase of the Project.

The reports are being exposed for interested party analysis and comment
and will inform discussions and conclusions reached by the Steering
Committee on each topic during the second phase of the Project.

It is envisaged that the second phase of the Project will involve
discussions of the Steering Committee about the key commonalities and
differences between the two regimes and will lead to policy decisions by
their respective organizations regarding whether and how to achieve
further harmonization in regulation and supervision.

The project is scheduled to come to a conclusion by December 31, 2012.

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The Contributing Parties

The Federal Insurance Office, U.S. Department of the Treasury

The Federal Insurance Office (FIO) of the U.S. Department of the
Treasury was established by the Dodd-Frank Wall Street Reform and
Consumer Protection Act.

The FIO monitors all aspects of the insurance industry, including
identifying issues or gaps in the regulation of insurers that could
contribute to a systemic crisis in the insurance industry or the United
States financial system.

The FIO serves on the U.S. Financial Stability Oversight Council.

The FIO coordinates and develops U.S. Federal policy on prudential
aspects of international insurance matters, including representing the
United States, as appropriate, in the International Association of
Insurance Supervisors.

The FIO assists the Secretary in negotiating certain international
agreements, and serves as the primary source for insurance sector
expertise within the Federal government.

The FIO monitors access to affordable insurance by traditionally
underserved communities and consumers, minorities, and low- and
moderate-income persons.

The FIO also assists the Secretary in administering the Terrorism Risk
Insurance Program.

The European Commission

The European Commission (EC) is one of the main institutions of the
European Union.

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P a g e | 46

It represents and upholds the interests of the EU as a whole. The EC is
the executive branch of the EU and is responsible for proposing new
European laws to Parliament and the Council.

The EC oversees and implements EU policies by enforcing EU law
(together with the Court of Justice), and represents the EU
internationally, for example, by negotiating international trade
agreements between the EU and other countries.

It also manages the EU's budget and allocates funding.

The 27 Commissioners, one from each EU country, provide the
Commission’s political leadership during their 5-year term.

The National Association of Insurance Commissioners

The National Association of Insurance Commissioners (NAIC) is the
standard-setting and regulatory support organization created and
governed by the chief insurance regulators from the 50 states, the District
of Columbia and five U.S. territories.

Through the NAIC, state insurance regulators establish standards and
best practices, conduct peer review, and coordinate their regulatory
oversight that is exercised at the state level.

NAIC staff supports these efforts and represents the collective views of
state regulators domestically and internationally.

NAIC members, together with the central resources of the NAIC, form
the national regime of state-based insurance regulation in the United
States.

European Insurance and Occupational Pensions Authority

The European Insurance and Occupational Pensions Authority (EIOPA)
was established as a result of the reforms to the structure of supervision of
the financial sector in the European Union.

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P a g e | 47

The reform was initiated by the EC, following the recommendations of a
Committee of Wise Men, chaired by Mr. de Larosière, and supported by
the European Council and Parliament.

EIOPA technically supports the EC, amongst others, in the
modernization of the EU’s insurance regulatory and supervisory regime.

Current work aims to further specify the Solvency II Framework Directive
with technical rules and guidelines, which is necessary for a consistent
application by insurers and supervisors of the framework. In cross-border
situations, EIOPA also has a legally binding mediation role to resolve
disputes between competent authorities and may make supervisory
decisions directly applicable to the institution concerned.

EIOPA is part of the European System of Financial Supervision
consisting of three European supervisory authorities, the others being the
national supervisory authorities and the European Systemic Risk Board.
EIOPA is an independent advisory body to the EC, the European
Parliament and the Council of the European Union.

EIOPA’s core responsibilities are to support the stability of the financial
system, transparency of markets and financial products as well as the
protection of insurance policyholders, pension scheme members and
beneficiaries.

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NUMBER 4

Five Questions about the Federal Reserve and
Monetary Policy
Chairman Ben S. Bernanke, at the Economic Club of
Indiana, Indianapolis, Indiana
Good afternoon. I am pleased to be able to join the Economic Club of
Indiana for lunch today.
I note that the mission of the club is "to promote an interest in, and
enlighten its membership on, important governmental, economic and
social issues." I hope my remarks today will meet that standard.
Before diving in, I'd like to thank my former colleague at the White
House, Al Hubbard, for helping to make this event possible.
As the head of the National Economic Council under President Bush, Al
had the difficult task of making sure that diverse perspectives on
economic policy issues were given a fair hearing before recommendations
went to the President.
Al had to be a combination of economist, political guru, diplomat, and
traffic cop, and he handled it with great skill.
My topic today is "Five Questions about the Federal Reserve and
Monetary Policy."
I have used a question-and-answer format in talks before, and I know
from much experience that people are eager to know more about the
Federal Reserve, what we do, and why we do it.
And that interest is even broader than one might think.
I'm a baseball fan, and I was excited to be invited to a recent batting
practice of the playoff-bound Washington Nationals.
I was introduced to one of the team's star players, but before I could press
my questions on some fine points of baseball strategy, he asked, "So,
what's the scoop on quantitative easing?"

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P a g e | 49

So, for that player, for club members and guests here today, and for
anyone else curious about the Federal Reserve and monetary policy, I will
ask and answer these five questions:
What are the Fed's objectives, and how is it trying to meet them?
What's the relationship between the Fed's monetary policy and the fiscal
decisions of the Administration and the Congress?
What is the risk that the Fed's accommodative monetary policy will lead
to inflation?
How does the Fed's monetary policy affect savers and investors?
How is the Federal Reserve held accountable in our democratic society?
What Are the Fed's Objectives, and How Is It Trying to Meet
Them?
The first question on my list concerns the Federal Reserve's objectives
and the tools it has to try to meet them.
As the nation's central bank, the Federal Reserve is charged with
promoting a healthy economy--broadly speaking, an economy with low
unemployment, low and stable inflation, and a financial system that
meets the economy's needs for credit and other services and that is not
itself a source of instability.
We pursue these goals through a variety of means. Together with other
federal supervisory agencies, we oversee banks and other financial
institutions.
We monitor the financial system as a whole for possible risks to its
stability.
We encourage financial and economic literacy, promote equal access to
credit, and advance local economic development by working with
communities, nonprofit organizations, and others around the country.
We also provide some basic services to the financial sector--for example,
by processing payments and distributing currency and coin to banks.

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But today I want to focus on a role that is particularly identified with the
Federal Reserve--the making of monetary policy.
The goals of monetary policy--maximum employment and price
stability--are given to us by the Congress.
These goals mean, basically, that we would like to see as many Americans
as possible who want jobs to have jobs, and that we aim to keep the rate of
increase in consumer prices low and stable.
In normal circumstances, the Federal Reserve implements monetary
policy through its influence on short-term interest rates, which in turn
affect other interest rates and asset prices.
Generally, if economic weakness is the primary concern, the Fed acts to
reduce interest rates, which supports the economy by inducing
businesses to invest more in new capital goods and by leading
households to spend more on houses, autos, and other goods and
services.
Likewise, if the economy is overheating, the Fed can raise interest rates to
help cool total demand and constrain inflationary pressures.
Following this standard approach, the Fed cut short-term interest rates
rapidly during the financial crisis, reducing them to nearly zero by the end
of 2008--a time when the economy was contracting sharply.
At that point, however, we faced a real challenge: Once at zero, the
short-term interest rate could not be cut further, so our traditional policy
tool for dealing with economic weakness was no longer available.
Yet, with unemployment soaring, the economy and job market clearly
needed more support.
Central banks around the world found themselves in a similar
predicament.
We asked ourselves, "What do we do now?"
To answer this question, we could draw on the experience of Japan,
where short-term interest rates have been near zero for many years, as
well as a good deal of academic work.
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Unable to reduce short-term interest rates further, we looked instead for
ways to influence longer-term interest rates, which remained well above
zero.
We reasoned that, as with traditional monetary policy, bringing down
longer-term rates should support economic growth and employment by
lowering the cost of borrowing to buy homes and cars or to finance capital
investments.
Since 2008, we've used two types of less-traditional monetary policy tools
to bring down longer-term rates.
The first of these less-traditional tools involves the Fed purchasing
longer-term securities on the open market--principally Treasury
securities and mortgage-backed securities guaranteed by
government-sponsored enterprises such as Fannie Mae and Freddie Mac.
The Fed's purchases reduce the amount of longer-term securities held by
investors and put downward pressure on the interest rates on those
securities.
That downward pressure transmits to a wide range of interest rates that
individuals and businesses pay.
For example, when the Fed first announced purchases of
mortgage-backed securities in late 2008, 30-year mortgage interest rates
averaged a little above 6percent; today they average about 3-1/2 percent.
Lower mortgage rates are one reason for the improvement we have been
seeing in the housing market, which in turn is benefiting the economy
more broadly.
Other important interest rates, such as corporate bond rates and rates on
auto loans, have also come down.
Lower interest rates also put upward pressure on the prices of assets, such
as stocks and homes, providing further impetus to household and
business spending.
The second monetary policy tool we have been using involves
communicating our expectations for how long the short-term interest rate
will remain exceptionally low.
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Because the yield on, say, a five-year security embeds market
expectations for the course of short-term rates over the next five years,
convincing investors that we will keep the short-term rate low for a longer
time can help to pull down market-determined longer-term rates.
In sum, the Fed's basic strategy for strengthening the economy--reducing
interest rates and easing financial conditions more generally--is the same
as it has always been.
The difference is that, with the short-term interest rate nearly at zero, we
have shifted to tools aimed at reducing longer-term interest rates more
directly.
Last month, my colleagues and I used both tools--securities purchases
and communications about our future actions--in a coordinated way to
further support the recovery and the job market.
Why did we act? Though the economy has been growing since mid-2009
and we expect it to continue to expand, it simply has not been growing
fast enough recently to make significant progress in bringing down
unemployment.
At 8.1 percent, the unemployment rate is nearly unchanged since the
beginning of the year and is well above normal levels.
While unemployment has been stubbornly high, our economy has
enjoyed broad price stability for some time, and we expect inflation to
remain low for the foreseeable future.
So the case seemed clear to most of my colleagues that we could do more
to assist economic growth and the job market without compromising our
goal of price stability.
Specifically, what did we do? On securities purchases, we announced that
we would buy mortgage-backed securities guaranteed by the
government-sponsored enterprises at a rate of $40 billion per month.
Those purchases, along with the continuation of a previous program
involving Treasury securities, mean we are buying $85 billion of
longer-term securities per month through the end of the year.

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P a g e | 53

We expect these purchases to put further downward pressure on
longer-term interest rates, including mortgage rates.
To underline the Federal Reserve's commitment to fostering a
sustainable economic recovery, we said that we would continue securities
purchases and employ other policy tools until the outlook for the job
market improves substantially in a context of price stability.
In the category of communications policy, we also extended our estimate
of how long we expect to keep the short-term interest rate at exceptionally
low levels to at least mid-2015.
That doesn't mean that we expect the economy to be weak through 2015.
Rather, our message was that, so long as price stability is preserved, we
will take care not to raise rates prematurely.
Specifically, we expect that a highly accommodative stance of monetary
policy will remain appropriate for a considerable time after the economy
strengthens.
We hope that, by clarifying our expectations about future policy, we can
provide individuals, families, businesses, and financial markets greater
confidence about the Federal Reserve's commitment to promoting a
sustainable recovery and that, as a result, they will become more willing
to invest, hire and spend.
Now, as I have said many times, monetary policy is no panacea.
It can be used to support stronger economic growth in situations in
which, as today, the economy is not making full use of its resources, and it
can foster a healthier economy in the longer term by maintaining low and
stable inflation.
However, many other steps could be taken to strengthen our economy
over time, such as putting the federal budget on a sustainable path,
reforming the tax code, improving our educational system, supporting
technological innovation, and expanding international trade.
Although monetary policy cannot cure the economy's ills, particularly in
today's challenging circumstances, we do think it can provide meaningful
help.
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P a g e | 54

So we at the Federal Reserve are going to do what we can do and trust that
others, in both the public and private sectors, will do what they can as
well.
What's the Relationship between Monetary Policy and Fiscal
Policy?
That brings me to the second question: What's the relationship between
monetary policy and fiscal policy?
To answer this question, it may help to begin with the more basic
question of how monetary and fiscal policy differ.
In short, monetary policy and fiscal policy involve quite different sets of
actors, decisions, and tools.
Fiscal policy involves decisions about how much the government should
spend, how much it should tax, and how much it should borrow.
At the federal level, those decisions are made by the Administration and
the Congress.
Fiscal policy determines the size of the federal budget deficit, which is the
difference between federal spending and revenues in a year.
Borrowing to finance budget deficits increases the government's total
outstanding debt.
As I have discussed, monetary policy is the responsibility of the Federal
Reserve--or, more specifically, the Federal Open Market Committee,
which includes members of the Federal Reserve's Board of Governors
and presidents of Federal Reserve Banks.
Unlike fiscal policy, monetary policy does not involve any taxation,
transfer payments, or purchases of goods and services. Instead, as I
mentioned, monetary policy mainly involves the purchase and sale of
securities.
The securities that the Fed purchases in the conduct of monetary policy
are held in our portfolio and earn interest.

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P a g e | 55

The great bulk of these interest earnings is sent to the Treasury, thereby
helping reduce the government deficit.
In the past three years, the Fed remitted $200 billion to the federal
government.
Ultimately, the securities held by the Fed will mature or will be sold back
into the market. So the odds are high that the purchase programs that the
Fed has undertaken in support of the recovery will end up reducing, not
increasing, the federal debt, both through the interest earnings we send
the Treasury and because a stronger economy tends to lead to higher tax
revenues and reduced government spending (on unemployment benefits,
for example).
Even though our activities are likely to result in a lower national debt over
the long term, I sometimes hear the complaint that the Federal Reserve is
enabling bad fiscal policy by keeping interest rates very low and thereby
making it cheaper for the federal government to borrow.
I find this argument unpersuasive.
The responsibility for fiscal policy lies squarely with the Administration
and the Congress.
At the Federal Reserve, we implement policy to promote maximum
employment and price stability, as the law under which we operate
requires.
Using monetary policy to try to influence the political debate on the
budget would be highly inappropriate.
For what it's worth, I think the strategy would also likely be ineffective:
Suppose, notwithstanding our legal mandate, the Federal Reserve were to
raise interest rates for the purpose of making it more expensive for the
government to borrow.
Such an action would substantially increase the deficit, not only because
of higher interest rates, but also because the weaker recovery that would
result from premature monetary tightening would further widen the gap
between spending and revenues.

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P a g e | 56

Would such a step lead to better fiscal outcomes? It seems likely that a
significant widening of the deficit--which would make the needed fiscal
actions even more difficult and painful--would worsen rather than
improve the prospects for a comprehensive fiscal solution.
I certainly don't underestimate the challenges that fiscal policymakers
face.
They must find ways to put the federal budget on a sustainable path, but
not so abruptly as to endanger the economic recovery in the near term.
In particular, the Congress and the Administration will soon have to
address the so-called fiscal cliff, a combination of sharply higher taxes
and reduced spending that is set to happen at the beginning of the year.
According to the Congressional Budget Office and virtually all other
experts, if that were allowed to occur, it would likely throw the economy
back into recession.
The Congress and the Administration will also have to raise the debt
ceiling to prevent the Treasury from defaulting on its obligations, an
outcome that would have extremely negative consequences for the
country for years to come.
Achieving these fiscal goals would be even more difficult if monetary
policy were not helping support the economic recovery.
What Is the Risk that the Federal Reserve's Monetary Policy
Will Lead to Inflation?
A third question, and an important one, is whether the Federal Reserve's
monetary policy will lead to higher inflation down the road.
In response, I will start by pointing out that the Federal Reserve's price
stability record is excellent, and we are fully committed to maintaining it.
Inflation has averaged close to 2 percent per year for several decades, and
that's about where it is today.
In particular, the low interest rate policies the Fed has been following for
about five years now have not led to increased inflation.

_____________________________________________________________

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